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Dividends vs. share buybacks: The pros and cons

For investors, what is better? Dividends give you cash, but share buybacks boost stock price.

George Cope, president and chief executive of Bell Canada Enterprises (BCE), speaks during the shareholders meeting in Quebec City on May 3. BCE has raised its dividend payment six times in the past three years. (MATHIEU BELANGER / REUTERS)

By Chad Fraser

Sun., June 3, 2012

At its annual meeting in February, Montreal-based CGI Group (TSX: GIB.A) Canada’s largest IT outsourcing firm, came under pressure from its shareholders to start paying a dividend.

That’s despite the fact that the company had spent $287 million on share buybacks in 2011, helping push the share price up 11.6 per cent during the year.

The question for investors is which form of reward is better. On balance, dividends are tough to beat, because they put cash in your pocket and give you the flexibility to decide what to do with it. But there are plenty of reasons to like buybacks, too, especially if you don’t need income from your portfolio right away.

Dividends are pretty straightforward: the company pays a certain amount for each stock held, usually on a quarterly basis.

If you take a company’s total yearly dividend payments and divide by its share price, you get the dividend yield, which shows you how much you’re getting back in dividends for each dollar you have invested. This is an important figure to consider when choosing dividend-paying stocks (though it shouldn’t be the only one).

For example, BCE (TSX: BCE) has raised its dividend payment six times in the past three years. Its quarterly payout is 54.25 cents per share (or $2.17 annually. Based on its current share price, that gives the stock a high 5.35 per cent yield.

Buybacks are a less direct way of returning cash to shareholders. Under a share buyback, a company purchases a certain number of its own shares. It may do this on the open market, like everyone else, or by making a tender offer to shareholders, usually at a slight premium to the market price. It then cancels the purchased shares, reducing the total number outstanding and so making each share worth that much more.

Going back to CGI, the $287 million the company spent let it take 14.8 million of its shares off the market in 2011, helping fuel the price gain.

Even though investors benefit from both buybacks and dividends, each has pros and cons. Here are five points to consider:

1. Information on dividends is easy to get: Look up any stock online or in the newspaper, and the dividend yield is easy to spot. Gains on buybacks, however, are much less tangible.

2. Buybacks let you defer taxes because you aren’t taxed on your gains until you sell your shares, while dividends are taxed in the year you receive them (unless you hold your shares in an RRSP). However, both dividends and capital gains are taxed at lower rates than ordinary income in Canada.

3. Dividends are a commitment. At least most investors see them that way, particularly those who rely on their portfolios for income. As a result, many companies are loath to cut their payouts and face the wrath of angry shareholders — and a likely selloff of their stock — unless it’s absolutely necessary.

4. Buybacks can be easily cut or slowed. Unlike dividend payments, holding off on buybacks won’t affect most investors’ view of the stock. CGI, for example, has said it will buy back up to 22.1 million more of its shares this year, but it’s under no obligation to do so. Many companies, in fact, never use all the funds their boards authorize for share repurchases.

However, this flexibility can be a plus for investors if, say, a company holds off on buybacks to invest in a profitable new opportunity or make an acquisition that will boost its profits.

5. Timing can play a big role in the effectiveness of buybacks. One criticism of buybacks is that management often gets it wrong and buys back shares when they are overpriced. Buyback critics often point to the third quarter of 2007 in the U.S., when S&P 500 companies bought back a record $172 billion of stock with the market near an all-time high. Buyback spending then dropped more than 85 per cent, to $24 billion, by the second quarter of 2009. During that period, the S&P 500 Index fell by about 47 per cent , meaning that companies had repurchased more shares when they were expensive and fewer when they were cheap.

Still, there is evidence that managers have learned from this experience. After steadily increasing their buyback spending since the second quarter of 2009, S&P 500 companies pulled back in the fourth quarter of 2011, spending 22.8 per cent less on repurchases while their share prices rose an average of 11.2 per cent. “Companies appear to have finally gotten it right,” said Howard Silverblatt, senior index analyst at S&P Indices.

It pays to look for companies that do both

For a good sign of investment quality, look for companies that have steady — and ideally rising — dividends and regularly buy back their stock. That can give you the best of both worlds: a mix of strong capital gain potential and reliable dividend income. BCE is one example; others include CN Rail (TSX: CN) and Tim Hortons (TSX: THI).

Of course, you need to look much deeper than dividends and buybacks when deciding which stocks to add to your portfolio, but these two factors can provide a good place to start.

Toronto writer Chad Fraser’s work has appeared on the TSI Network and Investing Daily investment websites.

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